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August 04, 2017

Crowe Horwath – On The Rocks in China

In the original version of “between a rock and a hard place” -- as Homer tells the story in Book 12 of the Odyssey -- when Odysseus sailed for home through the narrow straits between Scylla the six-headed monster and the deadly whirlpool Charybdis, he escaped the twin hazards at the cost of only six of his sailors’ lives.

No such luck for Crowe Horwath (HK) CPA Limited, the Hong Kong member firm of the eighth largest of the global accounting networks, and auditor of 22 modest-sized companies based in China and filing financial statements in the US with the Securities and Exchange Commission.

By its order dated July 27, 2017, the Public Company Accounting Oversight Board censured the firm and revoked its registration, for its refusal to produce documents to the PCAOB to enable its “access to the information that is necessary to be able to inspect (Crowe’s) audit work as required by the (Sarbanes-Oxley) Act and PCAOB rules” (¶ 2).

The audit firm defended its position based on a direction from the Chinese Ministry of Finance under that country’s laws. Sympathy is in order for Crowe Horwath’s global CEO, who Tweeted (@jkevingmcgrath), “Our Hong Kong member firm (is) caught between compliance with laws & regulations of the Chinese govt and their desire to comply with the PCAOB.”

Thus is brought forward a hostage to fortune that was embedded in the prospect of cross-border clashes of sovereign powers, immediately with the post-Enron enactment of Sarbanes-Oxley in July 2002 -- legislation that created the PCAOB and its inspection and oversight authority over the auditors of US-registered public companies.

That is, the PCAOB has been failing since 2002 to fulfill its members’ wishful promises of solutions to its inability to conduct inspections of Chinese firms – history dating to the PCAOB’s willingness to register non-US audit firms despite their explicit declarations of foreign legal impediments to compliance with its inspection regime.

The PCAOB’s revocation order made clear (¶ 10) that Crowe Horwath was to get no regulatory surcease under the May 2013 Memorandum of Understanding with the Chinese Securities Regulatory Commission and the country’s Ministry of Finance – deprecating that document (¶ 11) as a “non-binding agreement between the signing parties.” So stated, the PCAOB effectively conceded the internal inconsistency between the MOU’s “intent with regard to mutual assistance and the exchange of information for the purpose of enforcing and securing compliance with the respective Laws and Regulations of (the parties’) jurisdictions” and the bail-out that “it is ‘not intended to create legally binding obligations or…supersede domestic laws’ of the parties” (ellipsis in the order).

The PCAOB’s slap at Crowe Horwath might demonstrate effective agency muscle – or, as likely, could be foundational for dramatically unintended consequences. While the firm’s China-based US registrants will be forced to look elsewhere for audit services, there are broader reasons to be skeptical.

To start, Paul Gillis in his China Accounting Blog for July 26 calls out the agency to “pick on someone their own size” – with implications much deeper than a dig at the Big Four’s dominance of the large-company market in China.

Here is the context: at last count there were reportedly 92 Chinese companies with securities listed on the American exchanges. The upper end is totally dominated by the Big Four – of the ten largest companies in Standard & Poor’s index of the top 50 US-listed Chinese firms, PwC’s member firms audit six – Deloitte three – EY one.

Meanwhile, questions about accounting and reporting in China are fraught and persistent – the year-ago news of an SEC investigation into the accounting of Chinese giant Alibaba makes the point. An eruption of financial malfeasance in China is a simple inevitability, on a scale to have disruptive effect on the share prices of companies listed in America, to which the American regulators will be obliged to fashion a responsive strategy.

Those reactions will be intractably complicated. The SEC will be unable to secure documents and testimony, on the assumption that the Chinese securities regulator would exercise the veto granted in the largely illusory “settlement” of February 2015 – and the PCAOB will be prolonged in the paralysis of its fifteen-year inability to inspect.

Yet with its enforcement action taken against Crowe Horwath’s Hong Kong firm, the PCAOB has firmly nailed its policy colors to the mast – and (to thoroughly mix the metaphors of maritime hazard) will now, with its blind eye turned to the future, cruise merrily along until it too strikes the rocks.

That is because, to maintain any semblance of credibility as enforcer, it would seem obliged to maintain consistency with its sanction of Crowe Horwath, up the ladder of size to events involving Big Four clients. Yet – yanking the ticket of a Big Four firm in Hong Kong or China would have repercussions going to the heart of the global Big Audit model. Simply put, a regulatory deathblow against a Big Four firm in an economy the size of China would threaten the integrity and presage the collapse of a global Big Four network. And in turn, the limited range of auditor replacement choice renders impossible the functioning of a “Big Three” model – whether for the US-listed sector of large Chinese companies on its own or on the larger global stage.

Or put in Homeric terms – by pursuing Crowe Horwath between a rock and a hard place, the PCAOB may very well have sailed itself into those same troubled waters.

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.

And please also consider the comprehensive discussion of these issues in the new edition of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – just released by Emerald Books and available at Amazon.